Tips on Technicals - Bollinger Bands®
| Indicator type: |
Moving average envelope |
| Used to: |
Find market turning points, potential trading range breakouts and trend exhaustion |
| Markets: |
All cash and futures, not options |
| Works Best: |
All market types and time frames although daily is the most popular |
| Formula: |
The bands are curves drawn a number of standard deviations above and below a moving average. They are calculated as follows:
- Calculate the arithmetic mean (moving average) of the data
- Subtract the arithmetic mean from each of the individual data points used in the calculation producing a list of the deviations from the mean
- Square each of the deviations
- Sum the deviations, producing the total squared deviation
- Divide the sum of the deviations by the mean
- Take the square root of the result of step five
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| Parameters: |
20 period simple moving averages and 2 standard deviations are Bollinger's recommended parameters. This results in bands that contain 85% of the underlying item's prices. However, different intervals may require different mean and deviation calculations. For example, analysts trying to gain perspectives on long-term periods may find 50 day means with 2.5 standard deviation optimal. |
| Theory: |
Bollinger theorized that the band width of an envelope should be determined by the data-series itself rather than by the assumptions of the speculator, as done with percent envelopes. His theory states that a trading envelope's distance from the mean is a function of the market's volatility. |
| Interpretation: |
According to Bollinger, the key aspects are:
- Sharp moves tend to occur after the bands tighten to the average (volatility lessens).
- A move outside the bands calls for a continuation of the trend, not an end to it. Often, the first push of a major move will carry prices outside the bands. This is an indication of strength in an up market and weakness in a down market.
- A sharp move outside the bands followed by an immediate retracement of that move is a sign of exhaustion.
- Bottoms (tops) made outside the bands followed by bottoms (tops) made inside the bands call for reversals in trends.
- The bands can help in diagnosing double tops and bottoms, especially when the second part of the top (bottom) is higher (lower) than the first and lower (higher) in relation to the bands.
- The average should give support (resistance) in bull (bear) markets.
- A move originating at one band tends to go to the other band in consolidating or ranging markets. This is useful for projecting price targets early on and provides revised targets as events unfold.
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Above is a 330 day chart of Merck & Co., a NYSE stock. Note how the 20 day moving average provided resistance for the decline in early 1993. When the trend reversed in April 1993, the first correction of the new rally was supported by the average. Later, when the market reversed lower in June, the average provided resistance to the first correction higher.
When prices move outside the bands, the following analysis can be applied:
- Sharp moves after a relatively calm market tend to occur after the bands tighten to the average (volatility lessens). In November 1993 the bands became quite narrow and that was followed by a quick three point move.
- Reason -- market participants have slowed their activities and are waiting for the market to tell them where it is heading. Once a move starts, everybody jumps in.
- A move outside the bands calls for a continuation of the trend, not an end to it.
- Reason -- volatility has not expanded yet to compensate for the new trend. Other indicators, such as RSI, can confirm this.
- Bottoms (tops) made outside the bands followed by bottoms (tops) made inside the bands call for reversals in trends. Note how Merck made a new high in December 1992 outside the bands while the next price peak occurred inside the bands.
- Reason -- market participants have not accepted the increase in volatility and therefore look for wide price swings to take profits.
